Steve Chamberlain

Updated May 11, 2007

 

The two basic accounting equations.

            The first basic accounting equation is also the form of the Balance Sheet, to wit:

 

            Assets = Liabilities + Equity

 

The second basic accounting equation is the key to the “double entry” accounting system, to wit:

 

            Debits = Credits

 

In essence, the second equation says that if you change something on the Balance Sheet, you must change something else to keep the equation balanced  (i.e., “balancing the books.”)

            Accounting information is broken down into separate accounts in order to track transactions by subject matter (e.g., the “cash account”). Asset accounts are natural debit accounts. Liabilities and equity accounts are natural credit accounts.   Note that negative numbers are avoided because each transaction is recorded via at least two positive entries in which the sum of the debits equals the sum of the credits. For example, borrowing money is one transaction which consists of an increase in an asset account (debit cash) and an increase in a liability account (credit debt to bank) by the same amount - thus keeping the Balance Sheet balanced.            

            The “double entry” system is just simple algebra with a twist to enable clerks to enter transactions by following a recipe without having to understand what they are doing. It also allows relatively easy checking for errors, such as: “just add all the debits and credits of all of the accounts and see if they balance.”

            Each transaction is entered in chronological order on the “ledger”with the debit entries first, followed by the credit entries (with the latter indented). Each entry within the transaction has the name of the account and the dollar amount, with debits on the left and credits on the right. Comments can be made below the accounting entries before the next transaction is recorded.   For example, starting a business with a cash infusion of $1,000 could be recorded (“booked”) as

 

Transaction      Date               Description                    Debits             Credits 

    1.                 1-19-07            Cash                            $1,000

                                                      Equity                                             $1,000 

                      To record cash infusion by Owner to start the business. 

            Each account has its own “journal”(e.g., the “cash journal”) which contains each debit and credit entry affecting that account.  A common accounting practice is to “reconcile” the checking account, which is a simple process to assure that the bank’s accounting and the company’s accounting regarding the company’s bank account are the same.

 

Financial statements. 

            The purpose of accounting is to provide financial information in a useful format. Thus the choice of what accounts to use is governed by business and tax considerations. The accounting information is commonly summarized via “Financial Statements”. The most basic financial statement is the Balance Sheet, which is essentially described above. 

            The Profits and Loss Statement (a.k.a. P&L or Income Statement) can be thought of as a summary of changes to all of the accounts within the Equity portion of the Balance Sheet over some period of time, other than those accounts which record transactions with the owners qua owners (i.e., other than contributions or distributions of capital). Hence, “income” accounts are natural credit accounts representing increases in equity not resulting from contributions by an owner; while “expense” accounts are natural debit accounts representing decreases in equity not resulting from distributions to an owner. For example, making a mortgage payment would be recorded (“booked”) as 

                                                                     Debits                      Credits 

2.        Mortgage debt  (liability)           principal reduction

           Interest expense (equity)          interest expense                         Cash   (asset)                                                          mortgage payment 

 

            The Balance Sheet is a snapshot picture, while the P&L is a summary of income and expense accounts over some period of time. Typically, the bottom line of the P&L (net income/loss) is shown in the equity portion of the Balance Sheet in lieu of all of the income and expense accounts. Where the time period of the P&L does not stretch back to the beginning of the company (e.g., the P&L only covers the current year), the bottom line of the P&L for the previous periods is shown as Retained Earnings on the Balance Sheet. However, Retained Earnings is debited for distributions to owners, the idea being to only show the portion of the previous income that has not been distributed to the Owners, rather than clutter the Balance Sheet with more detailed information.

            The third common financial statement is the Source and Uses of Cash. This is also a summary of transactions over a period of time. It begins with beginning cash on hand.   Net income (loss) for the same time period is added as a source of cash (or subtracted as a use of cash).   Adjustments are then made for non cash transactions which affected the P&L (e.g., depreciation expense is a “source” of cash because it reduced net income and net income was already included in the Statement as a source of cash) and for cash transactions which did not affect the P&L (e.g., purchasing land as a “use” of cash and borrowing is a "source" of cash).  The bottom line of the statement is ending cash on hand. 

 

Capitalizing vs. expensing.

            A common accounting problem involves the question of whether certain expenditures should be “capitalized” or “expensed”. For example, should an expenditure on fixing up a building be treated as a repair (deductible expense) or an improvement (asset), with an obvious impact on income depending on how the expenditure is treated.   Needless to say, the answer often depends on who is asking the question. One principle - which may or may not help in deciding how to treat the expenditure - states that if the expenditure resulted in the creation of an asset which is expected to last more than one year, it should be capitalized. Another principle is that similarly situated companies should be treated similarly. For example, if one purchases a restaurant, the expenditure creates an asset on the buyer’s books. Equal treatment demands that if one spends money to open a restaurant (instead of buying an already operating restaurant), then pre-opening expenditures (e.g., on training staff) should be capitalized. Note, however, that in both cases expending money to hire and train staff after the restaurant has opened is an operating expense.

 

Methods of accounting

            Methods of accounting are arbitrary rules primarily concerned with the timing of recording income and expense transactions. The cash method of accounting provides that income transactions are recorded when the money is received and expense transactions are recorded when the bill is paid. The accrual method of accounting requires that income be recorded when the right to receive the income arises (e.g., sending out the bill) and expense be recorded when a bill is payable. Books kept on the cash method of accounting usually do not include accounts receivable or accounts payable, which means such information, if desired, must be kept “off the books”.   The accrual method of accounting is considered a “better”method in the sense that it is more likely to more accurately reflect economic income, and for such reason is always permitted by the IRS. The cash method is preferred by many profitable small businesses in those cases where it is a permissible method of accounting for tax purposes. The cash method is easier to maintain and usually results in deferral of taxable income (assuming accounts receivable exceed accounts payable). 

            Efforts to standardize the reporting of financial transactions resulted in so-called Generally Accepted Accounting Principles, or “GAAP”. GAAP is commonly used in preparing financial statements of larger businesses, but is not a commonly used method of accounting for small businesses or for tax reporting purposes.

            Assumptions are often made which enable transactions to be recorded in particular ways. For example, suppose a computer is purchased for $3,000 (debit computer, credit cash). One could simply wait until the computer is worthless and then “write off” the computer (credit computer, debit equipment expense). But the goal of achieving a better matching of accounting and economic information demands that the computer be written off gradually. A common way of accomplishing that result is the straight line method of depreciation, which is a method of accounting for depreciation expense. Under this method an assumption is made about the useful life of the asset, such as the computer will be worthless in three years. Applying the straight line method would mean that each year $1,000 of depreciation is recorded (debit depreciation expense, credit computer). 

 

Economic vs. accounting income

            Distortions between economic income and accounting income should be expected. For example, if an asset increases in value, the owners’ net worth has increased (economic income), but the increase would not normally be recorded on the books. Bill Gates may be the richest man in the world, but almost all of his wealth could be shown on his personal books as Microsoft stock at the value he paid for it when working out of his garage.